Wednesday, November 20, 2013

REPOST: Sales "bunching" and high-powered commission rates

Ian Larkin studies the use of "high powered" quarterly sales commissions, used by virtually every firm that sells software. A typical incentive compensation scheme (as a function of sales) is highly convex: a sales person earns 2% if she sells $100,000 worth of software; 5% if $500,000; 8% if $1,000,000, ..., up to 25% if $8,000,000.

Ian finds that these high-powered (convex) compensation schedules give sales people an incentive to "bunch" sales into the same quarter. Just as concave production costs can be reduced by "smoothing", i.e., holding inventories to buffer sales shocks, so too can convex commissions be increased by "bunching" sales into the same quarter, the opposite of "smoothing."

Using proprietary data from a large vendor he finds that 75% of sales are occur on the last day of the quarter; and 5% of sales occur on the first day of the quarter, as sales people give discounts to customers to accelerate or delay purchases. These discounts cost the firm about 7% of revenue, which is about the same amount that it pays out in sales commissions.

The 7% revenue loss suggests that there is a way to make both firm and its salespeople better off: adopt linear commission schemes to eliminate the incentive to "bunch," and split the 7% savings between the firm and its sales people in the form of higher commission rates.

When asked why they use these costly incentive compensation schemes, managers say only that they need them to retain their "superstar" sales people. But surely there is a better way to retain superstars, isn't there? As always, I would like to hear from readers on whether they think this would work.


  1. I agree that this doesn't make any sense to compensate your employees this way, there is some truth to the retention comment. Sales forces are some of the most mobile/movable of any profession. If another company has a more advantageous incentive structure, they will more than likely move.

  2. Sales organizations are usually driven towards a single goal: make sales. Oftentimes, sales organizations are not charged with profitability, and their concentration is upon the top line of sales. High-powered (convex) commission structures reward top performers, and these top performers become fixated on maximization of their income, along with the competition for the top sales award. Such factors retain the top performers and “weed out” those individuals who are lackadaisical and cannot make enough sales to warrant income.

    To answer Froeb’s question, management can
    retain “superstar” sales people and encourage them to meet company goals. Foremost, compensation needs to reward the performance the company targets. This can be accomplished through analysis of sales, whereby the company can adjust the commission structure to incorporate a factor for the discounting done by the sales person. For example, in many small automobile dealerships sales people are paid a minimal amount for each automobile sold within a price range (i.e., retail price down to a percentage off of list price). If a sales person wants to go below that price point to sell an automobile, than that portion of the lower price comes out-of-the sales person’s commissions. The logic being a lower commission structure is better than not having a no sale/no commission. Since automobile sales are sporadic in nature, sales people in the automobile business are usually on a draw, which smooth out their cash-flow.

    To counter the impact of discounting and a reduced commission, management can create a new profitability bonus based on the total margin generated by the sales person for the quarter. As with examples in the textbook, marginal analysis should be done on variable expenses that are influenced by the sale, and not all fixed costs for the business (Froeb, McCann, Shor, Ward, 2014, p. 39). By setting targets that improve the organization’s margin, educating the sales person on the components and the benefits of achieving or exceeding this goal, the sales person can be motivated to work towards accomplishing them.

    However, with any incentive, the sales person needs to balance garnering sales and predicting sales. If incentives are too heavily weighted to profits, some “good” sales may be lost in the total transaction. If predictability is not a meaningful award, than attaining sales with no matter to the cost becomes the sole motivator.

    Overall, sales recognition tools, including promotion, awards, trips, and praise can be minimal costs, but strong motivators for “superstar” sales people.

    Karen Whelpley

    Work Cited
    Froeb, L., McCann, B., Shor, M. and Ward M. (2014). Managerial Economics: A Problem Solving
    Approach. (Third Edition). Mason: South-Western Cengage Learning.